Our Outlook for Basic Materials Stocks
With demand weakening, input cost relief is the only hope for many basic materials companies in the first quarter of 2012.
Quarter-End Insights
- The outlook for the next long-term highway bill has gotten slightly more positive in the last three months, but our politicians still have a lot of work to do before the current continuing resolution expires in March 2012.
- Easing in raw-material cost inflation is the main hope for earnings improvement at many chemical companies in the early part of 2012.
- Persistent weakness in developed-market economies' demand for metals throughout 2011 put the onus on China to boost demand and prices for iron ore, metallurgical coal, and copper. Now that we see mounting signs of weakness in Chinese real estate markets, it's possible that the one leg of metals demand that had been relied upon for the past several years is finally beginning to shake.
There's no doubt now that many basic materials companies are facing weakening demand for their commodities. For example, higher prices to recoup higher input costs--rather than stronger demand--were the key driver of chemical companies' revenue growth in the third quarter of 2011. Even fertilizer companies, which had benefited from strong agriculture fundamentals through most of 2011, are beginning to see signs of risk-averse inventory management on the part of distributors.
Whether demand weakness for basic materials companies is a sign merely of destocking along various supply chains or a real indication of weakness with end-market demand, the effect on our companies is the same in the near term. We see relief on the input cost front as the only real opportunity for positive momentum in the very near term.
Industry-Level Insights
Agriculture
With crop prices weakening recently, the stock prices of many agriculture companies, particularly fertilizer producers, have also come down, despite another recent quarter of robust profit generation. Earlier in the year, fertilizer prices followed crop prices up and up, as tight supply impacted both markets. It seems prices marched high enough to create a measure of demand destruction for crops, as the U.S. Department of Agriculture has been lowering its demand numbers for corn, wheat, and soybeans over the last several months.
Fertilizer prices have yet to follow crop prices south, but we're expecting some easement in potash, phosphate, and nitrogen prices going into 2012. As crop prices drop, farmer revenues decline as well. With less money in their pockets, growers are more likely to skip fertilizer application of potash and phosphate, especially at current high prices. This dynamic holds not only for individual farmers, but also for large importing countries. A fertilizer official in India recently commented that the country's potash imports may drop by 30% to 35% this financial year because of higher prices.
While crop prices may drop further, we don't think prices will fall off a cliff anytime soon. Stocks-to-use ratios for crops are still at low levels, which should provide a floor to prices. Additionally, less-than-ideal growing conditions have led to declines in expected yields in North America for corn, wheat, and soybeans. While we'll be keeping an eye on crop and fertilizer prices, we're still expecting the string of strong results for fertilizer producers will continue in the fourth quarter. And with subpar yields in 2011, we're also expecting strong planted acreage in the 2012 North American growing season, which is a good volume indicator for crop inputs.
In the seeds industry, Monsanto recently disclosed impressive yield data for the 2011 harvest. We think yield will be an important determinant of the fight to win market share in the highly competitive seed industry. DuPont has proven a formidable rival for Monsanto, and we think yield advantages will be crucial to Monsanto maintaining its industry lead. Looking ahead, Monsanto recently raised its earnings guidance for the fiscal first quarter, a sign that its products are making headway in South America, which is in the midst of planting season.
Building Materials
The longer-term outlook for the U.S. highway bill has marginally improved lately. Infrastructure construction is one important source of demand for building materials such as cement and aggregates, but the U.S. has been operating without a long-term highway bill for the last couple of years. Continuing resolutions have provided short-term funds, but the lack of long-term certainty has prevented action on large-scale projects.
One of the central problems of the U.S. highway bill funding system is that it is tied to a fuel tax that has been kept flat for years and years, reducing the purchasing power of the program. In recent years, highway spending has surpassed fuel tax receipts, with the difference coming from program balances or the general fund. Earlier in 2011, the Republican-led House of Representatives had indicated that their proposal for the next highway bill would cut spending levels significantly to stay within the limits of fuel tax receipts. The Democrat-led Senate's proposal would keep spending at current levels plus inflation, with the difference being made up from general sources.
Recently, however, the House has indicated that it is also interested in keeping spending at current levels in order to support jobs (as unemployment has become a major concern). This is a good signal for long-term construction activity. The House has indicated that the extra funds could come from new oil and gas drilling leases, which promise to be controversial. Still, the House's new willingness to acknowledge the unemployment situation--which is especially high among construction workers--and preference for keeping highway spending at least at current levels are positive signals for cement producers.
Chemicals
Chemical producers are currently dealing with two sticky issues: 1) raw-material cost inflation throughout 2011 has forced companies to raise prices in an effort to maintain margins; and 2) worldwide demand, and particularly European demand, for chemicals looks like it's slowing.
Dow Chemical (DOW), a good temperature gauge for the chemicals industry because of the firm's large and diversified offerings, faced both of these issues in the third quarter. Dow's sales jumped 17% compared with the prior-year period, driven exclusively by price increases. Like its peers, Dow raised prices to combat raw-material cost inflation. Altogether, purchased feedstock and energy costs rose $1.7 billion compared with the same period in 2010, leading to a year-over-year decline in gross margin. Total company volumes were flat year over year, as weakness in North America and Europe was offset by growth in Asia-Pacific and Latin America. Ashland (ASH) and Eastman Chemical (EMN) are two more examples of chemical companies that battled flat volumes and higher-raw material expenses in the third quarter.
Looking ahead, we think raw-material cost inflation will begin to ease, giving chemical companies a chance to catch up with price increase and rebuild a portion of margin. In general, we believe companies selling differentiated products that afford a measure of pricing power will be more successful in this area. On the demand side, we think slowing global GDP growth will impact chemical maker volumes in the fourth quarter, and we expect the vast majority of revenue growth to come from price increases meant to offset higher input costs.
Exposure to end markets will also play a sizable role in near-term performance. Anemic construction growth in the developed markets will continue to weigh on chemical makers, but there is reason for optimism in other areas. PPG Industries (PPG) recently commented that it is expecting higher aerospace and automotive growth in 2012 compared with rates in 2011.
Coal
The coal industry has largely been in a holding pattern after a brutal third quarter. Continuing macroeconomic uncertainty all over the world is keeping coal equities near their 52 week lows. Companies that are exposed to Central Appalachia, that have metallurgical coal production, or that have made acquisitions recently (which are often one and the same) fared especially poorly. For example, Alpha Natural Resources , which ticks off all three boxes, is down 67% year to date, though the stock is up marginally since Sept. 30. James River , our least favorite coal miner, is down 73% year to date, and is roughly flat since the third quarter.
In general, despite the much lower equity prices, we are not very bullish on the sector. Our biggest worry is the direction that Chinese metallurgical coal demand will take over the next few years. China demand played a vital role in tightening global metallurgical supplies and driving prices to over $300 per metric ton earlier this year. Chinese demand depends heavily on domestic fixed asset investment--building highways, dams, houses, office buildings, and the like. However, evidence is accumulating that such torrid demand cannot continue forever. If the Chinese leg of the demand stool weakens, metallurgical coal prices can come down dramatically.
Over the past several years, U.S. coal miners, especially ones in Appalachia, have come to depend on metallurgical coal for the lion's share of operating profit, even as metallurgical coal is only a relatively small part of production. For example, Alpha and James River probably lose money on thermal coal. Arch Coal (ACI) is in a slightly better spot, as it has a better cost position. But after absorbing International Coal Group, the company will be very met focused as well. Even industry giant Peabody Energy is heavily dependent on met coal for its Australian profits. Since coal mining naturally has a very high degree of operating leverage, even a moderate downdraft in metallurgical coal has a fairly sizable impact on sector profitability.
For this reason, we continue to be more bullish on miners with a heavy concentration in thermal coals, especially the Powder River Basin. PRB pure-play Cloud Peak Energy continues to be our favorite coal miner. This stock has held up relatively well amid the industry carnage but is still down 18% year to date. Although PRB prices have been weak recently, we believe this low-cost basin is very well positioned strategically.
We are also fairly bullish on another PRB miner, Peabody Energy. Although we believe it destroyed several billion dollars of shareholder value when it acquired Macarthur Coal for $5 billion, the company still has a world-class asset portfolio with a favorable cost profile. That said, going forward the company will be much more economically sensitive and is set to produce the lion's share of profits from Australia as opposed to the U.S.
We remain lukewarm on Appalachian miners despite the much lower valuations available today. We believe the secular trends of higher costs and lower production will make it exceedingly difficult for the basin's operators to create shareholder value. We believe Alpha is still overvalued despite the 67% fall year to date. CONSOL Energy (CNX) might be an exception, as it is almost wholly in Northern Appalachia, which has better fundamentals. It is also more of a natural gas company with very large positions in Appalachia as well as the Marcellus and Utica. That said, profitability will remain relatively weak with natural gas prices below $4 per thousand cubic feet.
Forest Products and Packaging
Still-weak U.S. residential construction activity continued to weigh on timber and wood products operating results for U.S. forest products firms Plum Creek , Rayonier (RYN), and Weyerhaeuser (WY) in 2011. With few signs of life apparent in housing, the first quarter of 2012 is likely to mark a continuation of moribund performance. For most of 2011, export demand from China was a lone bright spot for timberland owners--at least those with significant landholdings in the Pacific Northwest. To the extent recent signs of weakening Chinese macroeconomic conditions accelerate in 2012, this happy corner of the timberland market could deteriorate in a hurry.
During the third quarter, packaging companies once again experienced robust top-line growth from emerging markets and lackluster performance in North America and Western Europe. Beverage can makers Ball (BLL), Crown Holdings (CCK), and Rexam continued to experience double-digit top-line growth in the emerging markets of Asia and South America as global brewers and bottlers continued to ramp up capacity, but they experienced lackluster volumes in North America and Europe where persistently high unemployment, poor summer weather, and increasing retail prices have exacerbated beer and carbonated soft-drink problems.
Although Ball, Crown, and Rexam are all trading at a discount to our fair value estimates, we believe that Ball's shares should exhibit the least volatility in the coming quarters. Given that Rexam has 10 beverage can lines in Italy, Greece, or Spain, and Crown has nine, versus Ball's zero, we believe that Ball is less susceptible to pullbacks in demand caused by the economic uncertainty and austerity in the European periphery.
Metals and Mining
Day-to-day news flow out of Europe meant a bumpy ride for most mining shares in the fourth quarter, much as it has for most of 2011. While continued uncertainty surrounding the continent's sovereign debt problems is likely to remain a key driver of mining share price performance in 2012, we expect Europe to cede some of the spotlight to increasingly shaky economic conditions in China. In particular, markets will be paying close attention to Beijing's policy response to several potentially worrying developments, including a sub-50 PMI reading in November (the first such reading since February 2009) and signs of weakness in the residential real estate market.
Although we'd expect any policy moves aimed at relaxing credit conditions to buoy mining shares in the near term (as we saw in the wake of the 50-basis-point cut to the reserve requirement ratio in early December), we'd caution that a shift toward easy money would risk re-inflating what, in our view, has become an unsustainable bubble in the real estate market.
Steel
Steel prices have begun their typical seasonal surge, with hot-rolled coil rising 20% since mid-November following multiple announcements of price hikes by the mills. Combined with the seasonal pickup we expect to see in steel consumption in the first quarter of 2012, with lead times already extended into February on many products, the top line should produce healthy sequential growth to follow a very weak fourth quarter.
But the biggest improvement we expect to see is in metal margins. Iron ore prices fell a whopping 30% in October, and while the volatility continues with a reversal in some of that decline, overall pricing for the quarter should be down at least 20% sequentially. This is particularly true for those that have renegotiated with the miners to achieve an immediate realization of those price declines in their input costs, as opposed to the quarter lag that previously prevailed. Scrap prices reversed much of their prior losses in December giving less cost relief for the mini-mills, however these are the producers with the highest exposure to spot shipments, and thus the most leverage to the upward trend in steel prices. The mills and service centers aren't quite in store for a booming start to 2012, and we expect the year ahead to bring only minimal demand improvement; however, the sequential trends are promising as the sector turns the page on a challenging end to 2011.
| Top Basic Materials Sector Picks | |||||
 | | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
 | |||||
| ArcelorMittal |  | $48.00 | Narrow | High | $28.80 |
| |||||
| Cameco |  | $27.00 | None | Very High | $13.50 |
| |||||
| Dow Chemical | | $36.00 | None | High | $21.60 |
| |||||
| Monsanto | | $80.00 | Wide | Medium | $56.00 |
| |||||
| Weyerhaeuser | | $28.00 | None | High | $16.80 |
| |||||
| Data as of 12-14-11 |
ArcelorMittal (MT)
ArcelorMittal is by far the largest player in a highly fragmented sector giving it a stronger ability to adjust to regional changes in demand. Its scale in distribution and diversity of raw-material sources is unmatched. On the raw-material side, we are just starting to see the increased earnings contribution from its mining investments, which not only give the company more leverage over less integrated players, but are highly profitable assets themselves. Its European exposure and high financial leverage are valid concerns, but we think these risks are fully priced into the shares, which are currently trading at 50% of their value on July 1. Consistent with our long-term view of the steel sector, we believe the stock price fails to take into account the company's earnings potential in the eventual cyclical upturn.
Cameco (CCJ)
We continue to view uranium miner Cameco as one of the best relative values on our mining coverage list. While all miners are to some extent dependent on the "China Story," the nature of Cameco's correlation is different than most. In contrast with iron ore, metallurgical coal, and copper--demand for which closely tracks Chinese gross capital formation (the stuff of infrastructure and real estate)--electricity consumption exhibits a closer correlation with general economic activity. Over the next 10 years, we expect to see a significant slowdown in gross capital formation growth rates versus the 14% real annual growth of the past decade, with household consumption accounting for a much larger share of economic growth. All else equal, we think uranium producers like Cameco are better positioned to weather this development than miners tied to the fortunes of fixed asset investment spending.
Dow Chemical (DOW)
Although Dow Chemical may struggle in the near term with higher-priced raw materials and volume weakness, we think the company is undervalued considering the firm's prospects for long-term profit generation. In our opinion, Dow's agriculture outfit and its electronics and functional materials business are the jewels of the company's portfolio, and each should help drive future growth. On the whole, Dow is in the midst of a transformation that aims to shift its product mix away from basic chemicals and toward specialty chemicals. Further, the company is looking to secure low-cost feedstocks globally through an asset-light joint-venture approach (highlighted by the Sadara project in Saudi Arabia). We think both moves will improve Dow's prospects.
Monsanto
With impressive 2011 yield data in its pocket and a fast start in South America, we think Monsanto is set up for solid results in 2012. The company is a wide-moat operator that, in our opinion, will generate shareholder value for years to come. After a difficult 2010, Monsanto took measures to right the ship, and 2011 was a bounce-back year for the company, with pricing and marketing strategies corrected. For the 2012 growing season, Monsanto will introduce its next promising product, refuge-in-the-bag corn, which has the potential to tilt the scales back in Monsanto's favor. While corn rootworm resistance has grabbed some headlines, we think the problem will ultimately prove to be a relatively small seed bump for Monsanto, as the firm's higher-margin SmartStax corn seed is positioned to help control the resistance issue. We think Monsanto's shares are moderately undervalued.
Weyerhaeuser (WY)
Weyerhaeuser remains our top pick among U.S. timberland owners, with its significant landholdings in the Pacific Northwest positioning the firm very well for an (eventual) recovery in U.S. housing starts. (See our July 27 report for details on our favorable outlook for Pacific Northwest timberland.) But given the moribund near-term outlook for U.S. housing starts, Weyerhaeuser investors will need to be patient. Importantly, the firm sits on an ample cash balance and has limited debt maturities in the coming years, a favorable liquidity profile that should mitigate the downside risk associated with continued housing-start weakness.
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